Executive Compensation and the Economics of Insurance

One of the things legal rules do is to allocate risk, so one of the subjects covered in teaching the economic analysis of law is the economics of risk allocation, conventionally put in terms of the economics of insurance. Designing optimal rules in this context is hard, because there are three different objectives and no reason to expect the rule that is best for achieving one to be best for the others.

The first objective is risk spreading—for familiar reasons, many people prefer a certain income of (say) $50,000 a year to a coin flip between $10,000 and $90,000, even though the average outcomes are the same. Insurance provides a way of converting the riskier outcome into the less risky.

The second objective is optimum incentives for controlling risk. Often, although not always, the same person who starts out bearing the risk is the one in the best position to take precautions against it. From this standpoint insurance is the problem, not the solution. Once I have insured my house or factory for its full value, the incentive to me to take costly precautions to make it less likely to burn down is low. In the extreme case, where an insurance company has been so imprudent as to insure something for more than its full value, the chance of a fire may become very large indeed. This is the problem described in the literature as moral hazard, not because taking risks is immoral but because “moral” in this context has an older meaning close to “psychological.” The hazard is due to the incentives of the actors, the moral not the physical characteristics of the situation.

The third objective has to do with the fact that the choices we make signal—imperfectly—information about our private information. That I want to buy lots of life insurance today is evidence that I know something the insurer doesn’t about my chances of living to tomorrow. That is a reason for him not to sell it to me, or only at a high price. The same argument applies, although less strongly, to anyone who wants to buy insurance against any risk that he has better information about than the seller. Wanting to buy is evidence that the risk is higher than average, a fact which the seller will take into account in pricing the insurance.

That is a problem if you face an average or below average risk but still, because of risk aversion, want to insure against it, provided you can do so at a price not much greater than the actuarial value of the insurance, a problem known in the literature as “adverse selection.” The classic example is the market for lemons. Sellers of used cars know more about them than buyers, so the fact that I want to sell my car signals that it is likely to be a lemon, so I get offered a lemon price, which makes it even less likely that I will sell it if it isn’t a lemon.

The same set of problems applies to executive compensation. One obvious way of better aligning the interests of executives with those of stockholders is to require the executives to be stockholders. To align the interests in the long term as well as the short, one could require executives not only to hold a sizable fraction of their personal wealth as stock in the company they work for but also to hold it under rules that prevent them from selling the stock or hedging it for some substantial period of time.

Arguably, this would be a good way of controlling not only moral hazard but adverse selection as well. An executive whose private information implied that hiring him would be bad for the company—perhaps because he planned to keep the job only until a better offer, expected shortly, came through, or because he planned to supplement his income at the expense of the stockholders—would have a good reason not to take the job on those terms, which is a second reason to insist on those terms when offering it.

On the other hand, requiring executives to invest a large fraction of their wealth in the stock of the company they worked for would be a very bad way of spreading risk. If the company did well, both the executive’s salary and his stock portfolio would go up. If it did well, both would go down. Better, from that standpoint, to spread the risk by owning stock in some company, practically any company, other than the one he works for.

In some contexts, some employees are paid with stock options that can only be exercised after a set period of time; I do not know if there are any precautions to prevent the employee from hedging his bet by selling the stock short before the time has expired. I also do not know to what extent the tactic described above is, or can be, implemented for executive compensation more generally. Clearly there are reasons both for doing it and against.

Comments welcome, especially from anyone who knows more than I do about the actual terms of the usual employment contracts for top executives.

How to Promote Liberty

I recently had a conversation with a wealthy libertarian, a successful entrepreneur, who wanted ideas for how to use both his money and the talents that had made it for him to spread liberty. It is not an easy question, nor is it one limited to libertarians; the same problem arises for people with other views who would like to promote them. Broadly speaking, I think there are at least three different approaches:

1. Political. Identify and support candidates who agree with your views and will try to implement them.

As I read the current news, Barack Obama is in the process of demonstrating why that approach mostly does not work. There are increasing signs of disappointment from people who supported him in the belief that his policies, both abroad and at home, would be radically different from those of his recent predecessors and are concluding that they will not be.

I suspect they are right. It is quite likely that Obama will expand the size of government, but the reason is not that he is a left-wing ideologue but that he is a practicing politician; the current financial crisis provides excuses to spend lots of money, a situation politicians are almost always glad to take advantage of. Given these circumstances, I expect that McCain would also have substantially expanded the size of government, just as Obama's predecessor did, with a different set of excuses.

2. Intellectual. Promote your ideas in colleges, in newspapers, in any way that will spread them, ideally to people themselves likely to be influential in passing them on.

This is a popular approach and probably does some good. Its limits come from the fact that the crucial resource in spreading ideas is not money but people, in particular smart people who like the ideas and are eager to expand and spread them. One H.L. Mencken or Adam Smith or, on the other side, George Bernard Shaw is worth many millions of dollar spent subsidizing ideological magazines or college lecture series.

This approach also has a danger, what I think of as the rice Christian problem. Rice Christians were Chinese who converted to Christianity because the missionaries had rice. In the political context, the equivalent are people who adopt an ideology because doing so is profitable--gets them a good job, government or private grants, and the like. One disadvantage of being the party in power is that your missionaries have a lot of rice, which increases the number of converts but can badly reduce their average quality. To a much more limited extent, that can happen with private donations as well.

3. Indirect. Find ways of spending your money that will encourage changes in the world whose effects go in the direction you want.

The most successful example that occurs to me, although it does not have a lot to do with libertarianism, is the invention of the birth control pill. My understanding--readers who are better informed on the subject are invited to correct it--is that its development was subsidized by a donor who thought a reliable form of female contraception would have social effects she approved of. I do not know how nearly the effects fitted her intention, but I think it is clear that that particular technological development had very large effects on the society and did so at the cost of a trivial investment.

A more recent libertarian example, on which the results are not yet in, is my son Patri's seasteading project. The idea is to develop an inexpensive technology for floating housing. The theory is, first, that it would make taxpayers more mobile, hence governments more competitive, and second that it would open up opportunities for small scale floating polities ouside the control of existing governments. My guess is that, like most such clever ideas, it won't work--but if it does, it could have very large effects over the next few decades in a direction that I would approve of.

Another possibility, which I do not think anyone is pushing at the moment, is the development of anonymous digital cash. Interested readers can find a discussion of the idea in my recently published Future Imperfect. So far it has not happened, probably because many governments would very much prefer that it not happen. But if it did come into existence, it could considerably reduce the ability of governments to control their citizens, especially in their online activities.

Readers are invited to contribute their own suggestions for how to spend money and talent promoting liberty--or, for that matter, promoting alternative large scale objectives.

One Small Problem

So far as I can tell, Obama's solution to the current economic problem is a "stimulus package," increased federal spending and either a tax cut or at least no substantial tax increase in the near term. The money has to come from somewhere; even allowing for the possibility that winding down the Iraq war, net of winding up the Afghan war, will free up some money, that is going to require a lot of federal borrowing.

What set off the Great Depression was a collapse of the money supply due to the failure of banks. What seems to be happening at present, to the extent that popular accounts can be believed, is a situation where it is hard for firms to borrow money--not a shortage of money but of credit. Having the government go onto the capital market and borrow an extra trillion or so in competition with other borrowers doesn't seem like a sensible way of improving the situation.

One Good Thing About the Election Outcome

I don't know whether Barack Obama will do a good or bad job of being President. But I think it is already clear that listening to him will be a pleasanter experience than listening to most politicians.

My most recent basis for that opinion is an interview with Sarah Palin, where she reports Obama, in a phone call, wishing her "luck--but not that much luck." A while earlier, I saw a news clip where Obama was discussing the question of what sort of a dog they were going to get for their daughters. He explained that this was a major issue, but there was a problem. They would like to get a puppy from a shelter, but one of his daughters had an allergy problem, so they needed a breed that was hypoallergenic. A dog from a shelter was unlikely to qualify since it would be "a mutt like me."

The general impression is not only that he is a competent speaker--most successful politicans are--but that he does not take himself too seriously.

And one bad thing? A President, House and Senate all held by the same party.

When a Pecuniary Externality Isn't

[Warning: About Economics]

The CEO of a corporation releases an optimistic report on its future prospects; the stock goes up. Six months later the future arrives and the optimism turns out to have been misplaced. The stock goes back down. An enterprising lawyer sues the corporation in a class action on behalf of everyone who bought stock between the two events, claiming that their loss when the price fell was due to their being fraudulently induced to buy at too high a price by the CEO's report and that since the CEO was an agent of the corporation the corporation is liable for their losses.

Arguably one problem with the argument, from the economic standpoint, is that the buyers' losses are the sellers' gains, hence the announcement did no net damage. It produced what economists call a pecuniary externality, an action by A that causes a transfer from B to C. That was the argument against fraud on the market suits that I offered in my Law's Order.

A more obvious example would be A becoming a physician, thus driving down the prices other physicians can charge for their services. That is an external cost to the other physicians but a matching benefit to their customers, so A is imposing no net negative externality. That is the economic argument in support of the well established common law rule that competition is not a tort--one firm can't collect damages from another just because the other's competition caused it to lose money.

Yesterday I read a paper, and heard a talk about it by the author, which provided a simple and interesting rebuttal. His argument was that the CEO is supposed to act as an agent for the existing stockholders--that, after all, is the theory of how a joint stock company works, even if imperfectly realized in practice. Everyone who gains from the temporary price rise by selling stock is someone who owned stock when the report was made and the price went up. So we can think of the CEO as acting not for himself nor for the firm, whatever that means, but for the existing stockholders. If we do, the externality is no longer pecuniary. It is merely an ordinary case of A taking an action that benefits him but injures B. The standard economic argument is that he will take such an action even if the gain (to him) is less than the loss (to B), hence the existence of externalities can result in actions that on net make us worse off.

Generalizing the point, whether we classify an externality as normal or pecuniary depends critically on what we assume about the relation between the actor and those affected. If A takes an action that benefits B at the cost of C that is a pecuniary externality--unless A had been talking with B first, and made some suitable arrangement to be reimbursed for helping him at C's expense.

It does not follow that fraud on the market suits are a good thing. Other objections can be made to the legal theory. But the objection I offered in Law's Order implicitly assumed that the CEO should not be viewed as a faithful agent of the current stockholders, an assumption it never occurred to me that I was making.

Earthquake Precautions and Judging Sources of Information

"When it strikes at 1000 local time, millions of participants across the region will 'drop, cover and hold on' - drop to the ground, take cover under a sturdy desk and hold on until the shaking stops."

(BBC news story on a planned massive earthquake drill in southern California)

Not long ago, I came across a fairly detailed discussion of earthquake precautions, somewhere online; unfortunately I no longer remember where. The author appeared to be well informed, with extensive experience in dealing with disasters.

According to him, "take cover under a sturdy desk" is lethally mistaken advice. The sturdy desk, table, or whatever is likely to have its less solid parts crushed, and you, under it, will in turn be crushed by its more solid parts. Where you want to be is next to the sturdy desk or equivalent--ideally, I suppose, between two of them--so that you end up with at least one end of the chunk of the ceiling that fell on you held up by the solider part of the desk, and you under it and uncrushed. He had similar critiques, along essentially the same lines, for other parts of the standard advice.

I have no independent information on the author's expertise and do not even remember where I saw the information. Nonetheless, I am on the whole more inclined to believe him than to believe the sources of the advice reported in the BBC story. Why?

There are basically three ways of judging sources of information. One is internal evidence--does the author sound like a competent, well informed person who takes reasonable care to make sure that what he says is true? A second is external evidence about the information--does it fit other things I have reason to believe are true? A third is authority--do I have good reason to believe that the source of the information is reliable?

The earthquake advice I read passed the first test and, to the extent I could apply it, the second--it was at least consistent with the relevant geometry and physics, and what little I know of the construction of ceilings and the appearance of collapsed buildings. I had no easy way of verifying the author's claimed expertise, so could not apply the third.

The advice reported by the BBC, at least in the forms have seen it in the past, passes none of the tests. It is presented in a "this is official information, believe it" form, with none of the explanations and qualifications that signal a source taking care not to overstate its claims. It is routinely offered as advice to schoolchildren, presumably the ones most likely to have a convenient desk available to hide under--and my observation of school desks suggest that they are unlikely to have legs strong enough to bear the weight of a collapsed roof. The source is typically not a single, identifiable expert but the sort of bureaucratic organization that sets up an earthquake drill for five million people or generates civil defense instructions to be distributed to schoolteachers and read to children. My experience with the information produced by such organizations in other context is that it reflects less a concern with being right than a concern with not admitting to having been wrong.

Absent further information, I don't plan to hide under a desk if there is an earthquake--especially not under a classroom desk, if I happen to be in a classroom at the time. Are there any readers out there who can point me at better sources of information on the subject?
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[Commenters pointed me at what is probably the piece I remember--on my son's blog. The ultimate source appears to be an article, "Triangle of Life," by Doug Copp. Snopes is critical of Copp. Looking at both of the pieces they link to (Red cross and Turkish) that critique Copp's arguments, I find their arguments rather less convincing than his; their strongest point is that building collapse is more likely in the third world disasters his arguments are largely based on than in a country like the U.S., where buildings are more solidly constructed, making optimal precautions different here.

I have not checked out the links Snopes provides to pieces that attack Copp rather than his arguments.]

A Proposal for Representative Government

"Democracy is the worst form of government, except for all those other forms that have been tried from time to time."

(Winston Churchill, from a House of Commons speech on Nov. 11, 1947)

The quote is usually offered as a defense of democracy. I prefer to read it as a critique of government. If the best form of government is still very bad, that is a strong argument against using government to do things.

I cannot, however, resist the temptation to offer my own proposal for an improved version of representative democracy. Not, I hasten to say, one that I have any reason to think would work better, merely one that more nearly lives up to the label. It works as follows:

1. Anyone who wishes may be a congressional representative.

2. Any voter may choose any representative to represent him, but only one at a time. A voter is free to switch from one representative to another on 24 hours notice--less if the relevant technology makes it practical.

3. A representative casts a number of votes in the house, or on committee, equal to the number of voters he represents.

4. Any representative representing at least 240,000 voters gets a seat in Congress, can introduce bills, speak on the floor of the House, act as a representative now does. Representatives with fewer than that number of votes can group with other such representatives to satisfy the requirement, giving them one seat which they can share among themselves in any mutually acceptable fashion. The limit can in the future be adjusted to keep the total number of seats in the house at about its present level.

I make no claim that this system would work better than alternatives, including the one we now have. It is, however, a more elegant solution to the problem of representative government than current systems and comes closer to justifying the label.

Was the Sexual Revolution a Mistake?

"Women have simple tastes. They get pleasure out of the conversation of children in arms and men in love."

H.L. Mencken

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My son Patri has a recent blog post raising the question of whether pornography may be harmful to relationships; he points out, correctly, that even if one thinks something should be legal it does not follow that it is desirable. In the same spirit, I want to explore the possibility that the sexual revolution, or at least parts of it, on net made the world a worse place. The argument has two parts:

1. One would expect the availability of reliable contraception and legal abortion to have sharply reduced the number of children born out of wedlock. In fact it was accompanied, in the U.S. and abroad, with a steep increase in that number. Correlation is not causation but it does raise the possibility of causation, especially when it goes in precisely the opposite of the predicted direction.

One possible explanation, which I have discussed elsewhere, looks at the effect of the link between sex and childbearing on the opportunities available to women who want children. In a world without contraception, sex and children are joint products. Rearing a child without a husband to help support you is hard, so women are reluctant to have sex without at least a commitment to marriage if a child results. Men want sex (as do women), but men don't get pregnant, and men arguably are less interested in producing children than women are. The result is that men are willing to commit to support children in order to get (among other things) a reliable source of sex.

Contraception and abortion break the link. Now women who don't want children and do enjoy sex provide an alternative for men who don't want to support children. Their competition drives down the price in commitment that women who do want children can charge to men who want sex. Hence women who want children often find that no suitable man is willing to commit to support them and end up as single mothers.

So far as the adults are concerned, there is no obvious reason to regard this as a bad thing; some people are better off, some worse off. Conventional economic analysis would show it to be a transfer plus a net gain; I leave the demonstration as an exercise for the reader.

But the adults are not the only ones concerned. It is widely believed, and may well be true, that children brought up in a single parent household end up with worse lives than those brought up by a married couple. If so, the gains to (some) adults may have been purchased at large cost to many children, and perhaps to others whom those children affect.

2. So far I have described marriage as only about sex and childbearing, and have implicitly assumed, as economists normally do, that the individuals involved act rationally. I now want to expand the first part of that and hedge on the second. Marriage is also about a complicated set of emotional and material benefits, what I think of as a nest, something that can exist without children and could even exist without sex. For a lot of people, men and women, the world is often a cold and lonely place, and it is nice to have somewhere you belong, with someone who loves you and whom you love.

In a world where non-marital cohabitation is for most people not an option--roughly speaking, the U.S. prior to the 1960's--the usual way of satisfying those desires is marriage. Because, in that world, marriage was seen as a very long term commitment, men and women were reluctant to engage in it without sufficient search to convince themselves that they had found the, or at least a, right partner. Sometimes they were wrong, but less often than if they had been willing to propose to the first even moderately plausible candidate.

In the current world, cohabitation provides many of the same short term benefits as marriage without the long term commitment. Once in such a relationship, however, both search and exit become harder than they were in the pre-marital state under the older system. If you have a nest to come home to, it can be hard to abandon it for the cold world outside and a renewed search. If you are fond of your partner, breaking up is hard to do even if an objective consideration persuades you that it is in the long term interest of both parties. Hence cohabitation may be continued, converted into marriage or the near equivalent, even if the parties are not as well suited to each other as would have been required for mutual assent to marriage under the old system.

At this point I am abandoning, or at least weakening, the assumption of rationality. Sufficiently rational partners would understand all this and choose between cohabitation and search accordingly. But rationality in this context is under pressure from two directions. Many of us are poor at making tradeoffs between short term and long term, as the usual state of my weight demonstrates. And the emotions associated with love, sex, and cohabitation may not be entirely conducive to rational thought. If so, the availability of an attractive short term substitute for marriage may result, in the long term, in ending up with the wrong person.

Palin, Cameron, Eisenstadt, Africa: Whom to Believe?

According to Carl Cameron of Fox News, Sarah Palin did not know what countries were in NAFTA or whether Africa was a country or a continent. According to Martin Eisenstadt, he was Cameron's source and he more or less made up the story, having helped brief Palin on foreign policy and concluded that she wasn't very well informed. According to multiple sources around the web, Eisenstadt himself is a hoax, a blogger at an imaginary thinktank who has no actual connection with the McCain campaign.

Various authorities online, many of whom accepted first the Cameron story and then the Eisenstadt admission for gospel, now have to choose between believing the original Cameron story, believing the Eisenstadt claim that it was bogus and he was its source, or believing the sources who "on background" (i.e. anonymously so far as readers are concerned) say that Eisenstadt was not Cameron's source. As best I can tell, nobody has any solid basis for any of those views. My own guess is that:

1. Eisenstadt wasn't Cameron's source and

2. Whoever the source was, the story itself was bogus.

Distractions Serial and Parallel

Some years ago I took an online test for diagnosing Attention Deficit Disorder, did not score high enough to qualify, but came close. That, plus reading about the symptoms and noticing that some were familiar from first hand observation, led me to send an email to my father and my adult son with the subject line "Did you know that we all have ADD?"

Patri replied with a learned disquisition on the proper diagnostic tests, on the basis of which we did not qualify. My father's response was "Your mother's been saying this for many years."

Patri also described to me a math professor of his at Mudd who had been diagnosed with ADD; he dealt with the problem by having multiple projects, switching from one to another when his attention flagged. That too sounded familiar. A few minutes ago I was working on a sequel to my second novel, a little before that checking how Future Imperfect was doing on Amazon (surprisingly well), before that reading about, and verifying for myself, an extraordinary bug in the Android software that runs on my G1 phone. And at the moment I'm writing a blog post. Once it's posted I'll probably check a few Usenet groups for ongoing conversations.

Two other features of my own practice may fit, in an odd way, with this. One is that I'm not very good at multi-tasking, a weakness quite striking when I am playing World of Warcraft and trying to pay attention simultaneously to what my character is doing, how much damage he has taken, what other characters are doing, and the text messages of what other characters, human and computer generated, are saying. My kids seem able to do all that while conducting one or two conversations on the side. For what may be similar reasons, I have no interest in online chat, but spend quite a lot of time reading and participating in threaded newsgroups. And the idea of instant messaging leaves me cold. I am happy to switch from one project to another, but I want to do it by my own choice, not because someone, or something, else has just demanded my attention.

All of which may also fit with a difference I noticed long ago between me and my friend and ex-colleague Richard Epstein. I argue, and think, in series; he does it in parallel. When I point out a hole in the line of argument he is pursuing his response is not to change his position, nor to try to fix the hole, but instead to point to another of the several parallel lines of argument he has running that can get him past the problem. I have no objection in principle to that as an approach to making sense of the world, but it makes my head spin.

I wonder if Richard has tried World of Warcraft.